As a lender, a BDC, and a firm with exposure to middle-market companies, Golub Capital BDC (NASDAQ:GBDC) faces a number of potential risks. Some of these are shared with its competitors and some of them are unique to the lending-based business model.
In this installment of our in-depth analysis of Golub, we'll take a look at some of the key risks the company faces.
Dealing with middle-market companies is inherently a risky proposition, for lenders and owners alike. Smaller companies might not have deep enough resources to cope with changing market environments, and growth can also be a source of weakness if it's too fast or outpaces infrastructure.
These companies are simply more volatile than your average blue-chip.
Golub credits its intense analysis process for its success, as there are obviously midsize companies that enjoy strong competitiveness and stability. It's the ability to select these companies and lend appropriately that determines whether a firm like Golub can be successful. The company's strategy sticking to mostly secured loans in an environment of easy money indicates a degree of level-headedness that I, for one, find appealing. I like my lenders predictable.
It also helps that Golub tends to hold onto its loans, which introduces an added measure of risk into the loan origination process -- keeping loans on the books means you have to really think about whether your borrower will pay. I like this too.
Interest rate risk
Aside from who you lend to, the other risk in lending is the changing interest rate environment. Right now interest rates are low, but what happens if and when they go up again?
Golub is partially reliant on the difference between the rates at which it can borrow and lend. Most of the firm's loans have floating interest rates, meaning that they'll rise with interest rates. But that isn't so profitable if Golub's borrowing costs also rise. Currently, Golub uses a combination of fixed and floating-rate loans and lines of credit to run its business. Though Golub hedges this risk to the extent they're allowed to, if interest rates change it's possible that the company could see compressed margins.
There is, of course, also a credit quality issue. If interest rates rise significantly, can Golub's borrowers continue to pay? One imagines that Golub takes these risks into account, but unforeseen circumstances can always come into play.
Golub, like many of its peers, uses leverage to magnify returns.
Leverage has the winning ability to make wins bigger; unfortunately, it can do the same to losses. There is also a cost to using leverage -- no one gets to borrow money for free -- and risks associated with easy access to it (the major risk being greed).
By BDC rules, Golub is generally required to have a 200% coverage ratio on borrowings, meaning that for every $1 borrowed it needs to have $2 in assets. There are exemptions to this rule for some of its subsidiaries, so overall the firm's coverage ratio may be below 200%.
That's a pretty good coverage ratio, especially when you compare it to the large banks, but of course the risk remains.
Risks related to shareholders
Finally, as a company that relies on shareholders for assets and performance income, Golub faces an additional set of risks.
First off, there's obviously a need for shareholders to stick around and, ideally, keep adding money (given the income distribution requirement). If the market goes down and shareholders panic, they might suddenly decide to sell their shares (lower share price notwithstanding), possibly making it harder for Golub to invest effectively through a downturn.
Secondly, there's a possible conflict of interest arising from the fact that Golub is paid an incentive fee, which means there's an incentive to push valuations and returns higher in order to boost compensation. While it doesn't look like any of that is happening, it's an important risk to be aware of when investing in BDCs.
Next Time: A look at the BDC industry and Golub's competitors.
Anna Wroblewska has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.